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ANNUAL OUTLOOK ASSET ALLOCATION

November 2021

The investment landscape in 2022

While bonds will suffer as rates rise, equities should deliver decent single digit gains as strong corporate profits offset a decline in stocks' earnings multiples.

01

Overview: Less of the same

For all the fears that markets are at a turning point, next year is likely to result in a continuation of 2021’s trends, albeit with ‘less of the same’. The economic and market recovery triggered by the removal of Covid lockdown measures is intact, if in its final phases. 

Record valuations, tighter monetary policy, expansionary fiscal measures and surging inflation point to modest gains for equities in 2022 following the market’s robust recovery from pandemic lows. A US rate hike next summer will push up global bonds yields, though the magnitude of the move will be mitigated by the fact that the US Federal Reserve and other central banks remain concerned about maintaining growth and employment rather than sticking narrowly to their inflation remits.

Based on our asset allocation framework, which takes into account economic conditions, liquidity, asset class valuations and technical readings, we expect equities to deliver single-digit returns for global stocks in 2022, with strong growth in corporate profits more than offsetting a contraction in equities’ earnings multiples.

Conditions for bond markets will be tougher, however, with US Treasuries (which set the trend for the fixed income market generally) expected to post losses on the year even though yields on the 10-year note will struggle to rise above 2 per cent. With real yields on inflation protected bonds at an all-time low, this part of the market will also fail to deliver for investors. In currency markets, the dollar will remain well supported despite trading well above fair value, largely thanks to the relative strength of the US economy.

Fig. 1 - Vital signs

Global economic indicators, Dec. 2019 = 100

AA1 global economic indicators

Source: Pictet Asset Management, CEIC, Refinitiv, CPB Netherlands, Google LLC. Data covering period 01.12.2019- 15.10.2021.

We believe the global economy will remain strong – at the very least returning to pre-pandemic trends of activity – with both growth and inflation above trend for another year. Vaccines, new anti-viral therapies and sensible precautions should limit the impact of Covid. 

Consumption of services should pick up, closing the gap with goods consumption –  and there’s significant upside here: hotel bookings and air travel reservations are still less than half of their pre-pandemic levels. At the same time, supply bottlenecks should ease with the lessening of mobility restrictions in key Asian economies . Not only will this feed end demand, but it will also allow for depleted inventories to be restocked. Overall, growth looks set to be comparable across regions and sectors and by the end of the year, and the global economy will broadly be back to normal (see Fig. 1). 

Overheating risks

Although with inflation marching higher there are concerns about stagflation, if there is a risk to our base case scenario, it’s that economies will overheat. Record corporate profits are boosting investment, while strong growth in both jobs and wage will feed through into higher consumption, as will a drawdown in what are record levels of excess savings globally. Notwithstanding some parallels with the 1970s, the global economy won’t be hit by a structural inflationary shock equivalent to the end of Bretton Woods, and thus the gold standard, in 1971. 

For the first time in living memory, the US economy will outperform China’s, growing at 5.6 per cent in 2022; it will also register a positive output gap - one that the IMF estimates will be the  largest in three decades. Inflation, driven by demand, will persist and unemployment will fall. Europe and Japan will also continue to recover, although lagging the US. We expect a similar outcome for the UK but with Brexit and potentially coordinated monetary and fiscal tightening creating uncertainty.

As for China, the start of the year is likely to be weak, a hangover from past monetary tightening and 2021’s regulatory clampdowns. But the second half of the 2022 should see a brisk recovery – with the caveat that there’s significant risk of a policy mistake that could damage the property sector, which accounts for a quarter of national output.

Even though, on balance, we sanguine about global growth, there are three specific risks to consider. Rising inflation – for instance a rapid surge in oil price to USD100 a barrel and beyond– could seriously dent demand. Further regulatory clampdowns in China can’t be discounted, either.  And then there's Covid– or more specifically the possibility that an even deadlier new variant that evades current vaccines could arise.

Fig. 2 - Winding down

Global fiscal and G5 monetary stimulus, % of GDP

AA2 fiscal and monetary stimulus

Source: Refinitiv, IMF Fiscal Monitor, Pictet Asset Management. Data covering period 31.12.2006-10.11.2021. *Weighted by G5 central bank assets in USD (our forecasts for 2021/22). **IMF forecasts.

Monetary policy is set to become less loose in 2022 (see Fig. 2)– even if there’s no outright U-turn. Emerging economies have already started to tighten and their real rates stand at 3 percentage points above those in developed markets, which is close to previous cyclical peaks. We expect the major central banks to expand their aggregate balance sheet by some USD1 trillion next year , compared to a USD2.7 trillion expansion in 2021. That’s less than the expansion of overall economic activity, meaning that excess liquidity will be shrinking for the first time since the global financial crisis. Nonetheless, real interest rates will remain negative despite the Fed’s tapering of quantitative easing and its expected rate hikes at the back end of next year. 

Although the US central bank will be monitoring economic developments, it’s hard for it to shift track once a policy course has been settled on. For example, in December 2015 it hiked rates even though core inflation was well below target and leading indicators were hinting at economic contraction. 

By contrast, the European Central Bank appears to be considerably more reluctant to move towards policy tightening. There’s more of a mixed outlook for the Chinese central bank which is having to balance between a soft economy and rising inflation.

Historically, at the start of a US monetary tightening cycle, equity returns drop to below the long-term average, though performance still tends to be positive. Any sudden declines in prices or increases in market volatility tend to be short-lived, even if they can be severe at times. 

But the warning stands: asset prices generally are richly priced after a decade of quantitative easing and cheap money and rising demand for financial assets from ageing populations. True, there remain pockets of value – energy, mining, Chinese property, Brazilian and Turkish equities, for instance – but many of these assets are all but uninvestible for many investors. Instead, investing has become a matter of finding relative attractiveness. Even so, as former Fed chairman Alan Greenspan once said: “history has not dealt kindly with the aftermath of protracted periods of low risk premiums.”

 
02

Equities: mid-cycle tug of war

For equities, the easy road is coming to an end after three years of stellar double-digit returns. However, we remain cautiously optimistic.

Record valuations, tighter monetary and fiscal policy and the surge in inflation will put pressure on stocks' earnings multiples. On the flip side, corporate profits should remain solid. The result of this typical mid-cycle tug of war should be single digit returns in 2022. We forecast around 5-10 per cent return for global equities, reflecting a 10 per cent decline in price-to-earnings (PE) ratios, 15 per cent growth in earnings (roughly double the consensus view) and a continued trickle of dividends (see Fig. 3). 

Tail risks include an economic overheating forcing central banks to speed up the pace of tightening and a significant growth deceleration in China spilling over to the rest of the world. The probability of these events is rising at the margin. But, on balance, the outlook for equities is still encouraging - not least because economic growth will be above average and financial conditions are likely to remain benign. 

Reassuringly, in contrast to the euphoria seen a year ago following news of Covid vaccine breakthroughs ,the latest investors’ surveys, positioning data and our own proprietary risk appetite index all suggest that this time investors are aware of the risks. This should help keep the overall market mood relatively sanguine.

A positive surprise for stocks may come in the form of pent-up demand, in what could be a repeat of 2021, when equities saw investment inflows of USD960 billion as investors’ decade-long preference for bonds started to wane.

Fig. 3 - Driven by earnings
MSCI All Country World Index – total returns (%) and breakdown by contributing factors
equities - total return

Source: Pictet Asset Management; Refinitiv. Data covering period 01.01.1990-10.11.2021.

Within equities, we expect cyclical value markets and sectors to outperform in 2022 as economies continue to re-open and bond yields rise. The tailwind from the economic recovery that should lift  earnings and profit margins is strongest in Japan. The market tends to outperform when monetary policy normalisation leads to higher real rates -  the scenario we believe will unfold in 2022.

Elsewhere, financials should continue to benefit from improved profitability from the banking sector as bond yields grind higher and lift lending margins. Gradual progress towards a close to pre-pandemic world should also benefit real estate and US small caps which appear particularly cheap.

As the pace of the regulatory crackdown eases, we see value in Chinese tech stocks following their significant underperformance in 2021.

In Europe, meanwhile, we prefer the periphery to core markets. Italy in particular is a clear beneficiary of Next Generation stimulus package, is trading at multi-decade valuation discount to the rest of Europe, and its equities are yet to reflect the optimism already embedded in its bond market. The UK looks attractive too given its value-tilt and a weakening currency.

Our view on the US is a bit more nuanced. On some metrics, US equities look very expensive: the cyclically-adjusted price-earnings ratio, for example, is now above 40 times, double its long-term average and at the same level as it was in 1999, shortly before the tech crash. But, when it comes to prospective returns, corporate earnings should come to the rescue in 2022, surpassing consensus forecasts thanks to robust economiic growth and, for now, resilient profit margins. Over the medium to longer term, however, we believe analysts are too optimistic on the evolution of profits, with taxes, interest costs and wage bills all set to rise. 

Elsewhere, remain very cautious on emerging market equities (and emerging market assets in general) in the short term. The current pace of growth in developed markets, especially in the US, makes the hurdle for EM outperformance very high when adjusting for the risks inherent in investing in the developing world. However, we think a rotation back to emerging markets is likely in the second half of 2022, contingent on improved macro-economic momentum and an end to - or significant slowdown in - the pace of monetary tightening across the developing world. 

Elsewhere, thematic investment should remain popular. The recent energy crisis has given a fillip to energy efficiency stocks, the spectre of wage inflation to increased automation, and the collective experience from the pandemic to companies that cater to consumers' evolving lifestyle choices.

03

Fixed income and currencies: another challenging year

Fixed income investors should brace themselves for another challenging year.

As the global economy recovers from the Covid recession, supply bottlenecks and rising energy and commodity prices are pushing inflation higher, prompting major developed and emerging market central banks to tighten monetary policy.

The US 10-year breakeven inflation rate -- a market-based measure of expected inflation -- recently hit a 15-year high of 2.6 per cent, a level which we think is near the upper end of the Fed’s tolerance threshold.

Markets are pricing in the possibility that central banks in the US, euro zone and the UK will have raised interest rates by at least once by the end of next year.

While central banks tightening is likely to be gradual for fear of raising borrowing costs too quickly or curtailing growth, conditions for bond investors are nevertheless at their most bearish in a decade – not least because valuations across fixed income asset classes are high.

Fig. 4 - Value gap

Fair value estimate of US 10-year yields with Fed balance sheet

FI fair value

Source: Refinitiv, Pictet Asset Management, data covering period 09.11.2006 - 09.11.2021

Against this backdrop, investors will have to look harder to achieve capital gains.

We like Japanese inflation-protected bonds. Japan’s real rates stand at -0.45 per cent – higher than those in the US and UK. The country’s inflation is rising as a weak yen – which is at a five-year low on a trade-weighted basis – pushes up import costs.

We also like US leveraged loans, which have attracted significant inflows this year thanks to low duration and a floating rate.

Corporate credit will struggle in the coming year, however, as developed market corporate spreads remain excessively tight, hovering near record lows in both investment grade and high-yield markets.

Within credit, however, one bright spot is short-duration bonds.

As we expect the yield curve to flatten next year, particularly in the US, investors do not gain any excess compensation for inflation risks through longer-maturity bonds.

Based on current yields and duration, short-term bonds will allow investors to better insulate themselves against volatility from interest rate fluctuations without giving up much yield.

For example, returns from US high yield bonds will be erased once yields have risen by 100 basis points, while returns for short-term high yield will remain positive until yields rise by 240 basis points.

We see little value in euro zone and other developed market government bonds.

Most have suffered over the past year and our models show the next 12 months are unlikely to be much different.

To make matters worse for investors, inflation-protected bonds are unlikely to offer attractive gains. They are among the most overbought asset classes and look unlikely to be able to repeat their year-to-date return of 6-7 per cent in developed markets.

However, we do not expect global real bond yields to surge from the current level, which is at an all-time low of minus 2 per cent.

Weak trend productivity growth – the anchor of real bond yields -- and sky-high savings are powerful secular forces keeping real bond yields in negative territory for the foreseeable future, in our view. The IMF forecasts that the global gross savings ratio to hit a record high of 28 per cent in 2022.

In this challenging backdrop for the asset class, Chinese government bonds continue to stand out with an attractive yield, a proven track record of diversification benefits and relatively muted inflation dynamics. What is more, they are denominated in a currency that we believe should appreciate over the long-term thanks to powerful structural trends. 

Elsewhere in emerging markets, we see value in Russian bonds, which have among the highest real rates among major countries.

We think EM corporate bonds are particularly attractive. These dollar-denominated bonds offer low duration and default rates are likely to stay low thanks to rising commodity prices.

Yields on JP Morgan CEMBI index are at an attractive 4.3 per cent, while high yield spreads between emerging markets and the US stand at the highest level since the previous 2018 peak.

In currencies, we expect the dollar to remain strong in the coming year despite trading as much as 20 per cent above what we consider to be fair value. The US currency should be supported by an outperformance of the US economy and demand for a reserve currency in times of rising global inflation.

In contrast, we think sterling will weaken as the UK economy may struggle to absorb interest rate hikes and fiscal tightening.

Other currencies, such as the euro and Swiss franc, should remain rangebound against the dollar.

We expect emerging market currencies, especially those of countries approaching the end of monetary tightening cycles such as Brazil and Russia, to become attractive from the second half of the year.

We believe that the bull market in commodities could extend thanks to strong demand from stock rebuilding and a decade-long underinvestment in infrastructure, as well as their inflation hedging qualities.